Understanding the basics of shares

Buy low sell high.  The share markets capture the majority of financial reporting and interest, but despite this the legal nature of shares is often misunderstood.

Most media attention on shares generally focuses on the secondary markets.  For example, Jane holds Qantas shares and sells them to Ricardo.  Qantas does not receive any money in this situation.  Ricardo now holds Qantas shares and is entitled to future dividend payments on them.  

For small business owners, most dealings with shares will concern the primary issuance of shares.  For example, your Australian start-up, Coffee Unlimited Pty Ltd wants to raise money from investors.  Coffee Unlimited issues $100,000 worth of shares to investors.  The company has received this money and will use it to hopefully grow its business.  The investors hold the issued shares and are entitled to future dividend payments on them.

In this article we set out the basic concepts required to understand shares.  If you’ve just started a small business now is the best time to familiarise yourself with these concepts to avoid unexpected surprises as your business grows.

What is a share?

A company is a legal entity and like a natural person it can own property, sue and be sued and it has to file tax returns.

A company must always have at least a single shareholder who holds at least one share; that person (or entity) owns the company.

Large multinationals may have billions of shares in issue.  The shareholders collectively own the company.  The percentage of shares they own generally reflects the percentage of the company they own.

But what actually is a share – can you touch it? Well, generally no.  A share is a set of contractual rights the shareholder has against a company.  The rights are recorded in the constitution of the company (or, if you don’t have one, the replaceable rules under the Corporations Act). 

The share may be represented by a share certificate that you can touch, but if the physical certificate is destroyed those rights will continue to exist (you may just encounter difficulty in proving it).  

So what can I do with shares?

Some shares are highly liquid.  If you have a share in a company listed on a stock exchange, you can probably sell that share for cash on the same day.  You could also offer those shares as security for a loan.  Other shares are highly illiquid; if you try to sell them it may be impossible to find a buyer (generally because the buyers cannot easily determine the value of your shares).

If you’ve just started a company, or just invested in a small business, it’s likely your shares are illiquid.  This means you may need to hold them for a long time before you get the chance to sell them, but as a holder you get to enjoy some contractual rights.

As the shareholder, you’re ordinarily entitled to your ‘share’ of the Company’s profits via dividend payments.  So as a sole shareholder that will be to 100% of any profit made.  Whether or not the Company makes a profit will depend on its performance, and the day to day control of the Company rests with the directors, not the shareholders.  

The directors are obliged to act in the best interest of the shareholders collectively and if the shareholders agree they can replace the directors.  In fact, provided a sufficient number of shareholders agree, they can cause the company to do or omit to do any lawful thing via special resolution.  They can also agree to wind up the company.

Larger companies may adopt tiered share structures: ordinary, preference, A, B, C and so on.  Each class will have its own rights as set out in the constitution.  Some classes may not have any right to the company’s profits.

Why should my company issue shares?

You may decide that your company should issue shares if you are looking to grow the company and fund it through external investment. These investors may include family and friends or any other potential investors you may contact.

Issuing shares also means you obtain capital without incurring debt.  However, generally shareholders will demand additional control rights in respect of your company.  For example, shareholders may vote on matters that pertain to the company’s business.  Exactly what rights are provided will be negotiated and agreed via the company’s constitution and, generally, a separate shareholders agreement.

Shares are also often issued to incentivise employees so that they share in the success of the company.  There are a number of different lawful tax arrangements in Australia designed to facilitate this, each with their own set of regulations that need to be adhered to.

Overall, there may be a number of reasons to issue shares in your company, however, it is important to be aware that share issuances and sales are regulated in Australia.  Failing to comply with these regulations can have serious consequences.

How to issue shares in a small company:

There are two usual ways to issue shares:

1.     Upon registration: Upon registration of the company, you will nominate the original shareholders and the amount they have paid for their shares . This will be recorded on your company registration form and the shares may be issued to the nominated shareholders once the company becomes registered with ASIC. 

2.     By Issuing new shares after formation: New shares may be issued after incorporation according to the process set out in your constitution, or if you do not have one, the replaceable rules under the Corporations Act.  The company will usually enter into a subscription agreement under which the company agrees to issue the shares and the investor agrees to pay for the shares.   

The issuance of shares affects control over a company so generally the company’s constitution and shareholder agreements will provide a strict process for how shares are to be issued.  For example, a company constitution or shareholder agreement may provide that existing shareholders have a right of first refusal to proposed offer of shares. This effectively gives existing shareholders priority to purchase the proposed share issue.

Compliance requirements

When you choose to issuer or transfer shares, the company has an obligation to inform ASIC of any changes to the company’s shareholders by filing a 484 form. You must also keep an updated member register that records all the shares that have been distributed and transferred.

The share register should include, at a minimum, the following details:

·       Names and addresses of shareholders

·       The date on which they purchased the shares and the value amount

·       The classes of shares and the number held by each member

Limits on number of shareholders

As a private company which is registered as a proprietary limited, you are limited to having 50 distinct shareholders that are not employees of the company.  This means that employees who hold shares, including directors and secretaries do not count when determining if you have met this maximum limit.

What is a Shareholder Agreement?

A constitution is a contract between the company and each shareholder.  However, shareholders will frequently seek additional rights directly against the other shareholders and therefore will enter into a shareholder agreement that is signed by all members of the company.

The shareholder agreement will ususally set out how the business may be managed and procedures for the sale and transfer of shares.

The shareholder agreement helps to set out mechanisms in which shareholders may settle disputes among one another.

Generally there is a lot of interaction between the constitution and shareholder agreement, you must read them together carefully.  You should also make it clear which document takes precedence in the event of any inconsistency.

What is the difference between a share and a stock?

There is no legal difference, just different names for the same thing.  You might also hear shares referred to as ‘securities’ or just ‘equity’.

What is the difference between a shareholder and a member?

As above, same thing different names.

What is share vesting?

This is a relatively common concept for startups that is included in a shareholder agreement.  The agreement will proivde that founder’s shares ‘vest’ over time.  Before they vest the shares can be bought back by the company for a nominal amount, usually $1.  Share vesting may be used mitigate the risk of the founder or employee leaving earlier than expected or failing to meet performance goals.

What are the different kinds of shares?

There are many different kinds of shares in existence, check the constitution to see the exact rights provided for each class.  The most commons shares are:

Ordinary Shares: these shares typically give the owner voting rights in the company, rights to dividends and distributions upon winding up.

Preference Shares: preference shares generally provide for superior payment rights over ordinary shareholders – the exact terms need to be set out in your constitution and/or shareholder agreement.  It’s common they are entitled to a ‘liquidation preference’ meaning that upon sale or liquidation they will be repaid in full (or at a multiple of original purchase price) before any ordinary shareholders are paid.

The types of shares the company may choose to issue depend on its goals.   At the end of the day, it is up to you to determine why, when, what and how shares will be issued by your company.

This article was written by Pippin Barry (UniMelb BA; JD) an Australian lawyer and Tom Xie (Unimelb BA) paralegal.